Recessionary Pressures Building
Our outlook for the economy continues to include a recession sometime this year or next. This view is supported by leading economic indicators that show significant slowing and are consistent with levels reached in the past three recessions (see red circles in accompanying chart, red vertical bars represent recession).
Pushing the recession into the future is the impact of almost $5 trillion in new debt to finance deficit spending in just over two years, a mind-boggling but stimulative sum. The Fed’s attempt to kill inflation through interest rate hikes will likely be achieved through recession. Though, the massive fiscal stimulus may make the recession shallower than it would have been otherwise.The economy has yet to fully digest the negative growth impact of raising the cost of debt by a factor of 2-3x in what was already a highly indebted economy.
Inflation Still Front-and-Center
The first three months of 2023 saw a tremendous runup in stocks. January started with a big rally but subsequently gave some back in February and March. Pushing stocks higher in the first weeks of the year was encouraging news that inflation was falling faster than expected,allowing interest rates to drift lower. Technology stocks reacted most favorably to lower interest rates, clawing back some of the losses attributable to rate hikes last year.Unfortunately, the encouraging inflation print in December was revised upward, followed by January and February inflation prints that came in higher than expected. Stickier inflation, at levels much higher than the Fed will tolerate, continues to support the Fed’s hawkish tone and additional rate hikes. As a testament to the Fed’s resolve, the most recent hike occurred only days after two banks failed, which in a lower inflation environment would have been enough reason for the Fed to pause.
The accompanying chart shows the current 3-Month Annualized Core PCE, the Fed’s preferred inflation measure, at 4.4%.. You can see the initial spike above 6% two years ago has moderated but has not fallen below 4% since. The Fed has a history of tunnel-vision, focusing on only one thing at a time, and today that focus is fighting inflation. If higher interest rates ultimately push the economy into recession, as we believe they will, the Fed will pivot their focus to recovery. For now, tightening policies will continue until the desired result – falling inflation – is plainly evident.
Bank Failures – Done or more to come?
The two bank failures in March were unique in some ways but most directly a result of losses on their high-quality bond portfolios, hurt by higher interest rates. Interestingly, loan performance at these banks had not deteriorated. How could they have mismanaged their interest rate/duration risk to such a catastrophic degree? While they were outliers in their exposures, they were not alone. Interest rates rose much faster than the Fed itself predicted only a year ago. In March of last year, the Fed’s forward 12-month consensus estimate for Fed Funds was to move up from 0% to 1.25%. Instead, short-term rates reached 5%, 300% higher than the Fed signaled only one year prior. No wonder most banks (and investors) were taken by surprise and not adequately hedged. Long-term high quality US Treasuries and Agency Mortgages, a large part of a typical bank’s capital base, declined -15% to -20% in 2022.
Silicon Valley Bank failed because of what can be described as a “digital bank run”. The advent of digital banking has allowed billions of dollars of deposits to be pulled instantly. When fear engulfed venture capital-oriented social media sites surrounding Silicon Valley Bank’s bond losses, depositors fled almost instantly with a few clicks. Depositors withdrew $42 billion – nearly a quarter of the bank’s total deposits – within a single day. The FDIC was forced to take the unusual step of closing the bank mid-morning the next day to shut down the bank’s servers.
The good news, and the reason markets have been so resilient, is that these losses were confined to AAA rated bonds that will mature at par, not to credit losses on customer loans. The initial market reaction to the bank failures was a rush to safety into US Treasuries whose prices spiked causing interest rates to fall significantly. The Fed quickly patched the problem with a new backstop program (called Bank Term Funding Program, BTFP) that, in effect, covers these losses since they will eventually mature at par.
The mini bank crisis was mostly shrugged off by investors, other than the regional bank sector which continues to underperform. Bank failures have been a feature of capitalist economies from inception and tend to cluster around recessions. While the failure of Silicon Valley Bank set off alarms, we are not currently seeing major underlying credit problems that would be needed for this to turn into something more systemic.
Regional Banks Have Investors Worried
Regional bank stocks sold off as fear of more bank runs spread. However, as this fear was allayed with the new backstop program, focus shifted to potential credit risks in commercial real estate. Small and regional banks dominate commercial real estate lending in the U.S. Worries that real estate values have peaked and office demand is in secular decline are growing. In addition, billions in real estate loans will need to be refinanced over the next few years, likely at much higher interest rates. In a slower growth economy, banks could begin to see non-performing loans in this sector. Further muddying the outlook is the likelihood of declining profitability for banks as they are forced to compete with higher yielding investments for deposits.
Stock Valuations Remain Elevated
Valuations contracted last year in response to higher interest rates, bottoming at 15x for the S&P 500 after starting 2022 at 22x, a -31% decline in the market P/E. The market bounce this year has brought the P/E back up to 18x, a level we believe is expensive in light of our macroeconomic view of above-average inflation and slowing growth. The equity risk premium, which compares earnings based equity returns to risk-free returns on US Treasuries, is at a 20-year low. This has created a disconnect between stock and bond valuations. In addition, the average dividend yield on stocks is 1.7% compared to US TreasuryBills of 5%. Earnings are likely to be down this year and interest rates are expected to remain relatively high which points to lower P/Es, not higher. Best case for stocks over the coming year is a shallow and short recession that investors can see past without losing confidence in long-term growth that resumes in 2024.
Stock market performance has been particularly uneven this year with 90% of performance coming from only 10 US mega-cap technology stocks. “Everyone Else”, as the chart below says, has been flat. The appeal of these mega-cap growth stocks makes sense given their post-COVID19
performance. They were a sort of safe-haven that provided defensiveness through the shutdown. Historically, an economic growth scare favores Utilities, Consumer Staples, and Health Care stocks, but that has not been the case this year.
We believe the era of below-target inflation, zero-bound interest rates, and slow-but-steady growth is in the rear-view mirror which will serve as a headwind to venture capital and speculative investing. That period favored growth stocks whose potential payoffs were high but often decades into the future. In the new world of higher inflation and interest rates, we believe investors will favor earnings visibility, cash generation, and a commitment to increasing dividends.
We remain cautious overall and allocated with the intent to “Protect” assets. However, we are ready to shift back into “Normal” when market opportunities present themselves. For now, higher yields on cash and bonds, combined with still strong risk-adjusted expected returns on alternatives, makes the opportunity cost of being underweight equity targets low.